Ask The Experts: September 4, 2019

Tony HatchIndependent Transportation Analyst and Consultant

Q: Rail volumes overall are continuing to decrease. What do you believe are the reasons for this?A: Volumes have been shockingly weak – we know there are six basic reasons. Here is the Wall Street Journal (WSJ) on “Railroads Carrying a Lighter Load as economy Slows”: https://www.wsj.com/articles/lighter-loads-weigh-on-railroads-11563235311?mod=searchresults&page=1&pos=1. The breakdown by rail is interesting – the Canadians are up (more so CP – up 6% to 1%); the Big 4 US all down ~4% (despite BNSF not “doing” PSR and CSX being the only one to publicly shed business). KSU was down “only” 1%. So, to determine what is going on, we need to determine how much weight we should put into each bucket:

1. The economy, still throwing off mixed signals - weakness in manufacturing (note autos, steel, housing) but “good jobs numbers”. Overall, consensus sees a slowdown, but not as bad as the usually correlating rail loadings would suggest.

2. Trade – yes, the recent threat to add tariffs to Mexican trade (in violation of NAFTA) was removed, for now, and there is a truce with China (note – that simply removed the (immediate) threat of further tariffs). But China has yet to resume purchasing US Ag (soybean) products. If nothing else, trade-by-tweet has severely disrupted the market. The dollar, meanwhile, was up 6% in Q2/19, which used to be good for international intermodal but….

a. China’s GDP growth for Q2 of 6.2% is both suspect and the lowest level in decades; US imports from the PRC are down 12% YTD-May. There is a lot of speculation about re-engineered supply chains away form China but the key issue is….to where? The answer seems to be – elsewhere in Asia, and to Mexico! But not re-shored – (The Economist) “There is little evidence of US manufacturing bringing production from China (back) to the US.”

b. Mexico – AMLO is going “off the reservation, as the whole imbroglio surrounding the resignation of his Finance Minister showed (see also BloombergBusinessWeek on his $8B (self-estimated) vanity project, the Mayan Train. Meanwhile, the economy may be tilting toward a recession (although the biggest YTD gain in exports to the US was Mexico +$10B while China was -$25B).

c. Trade overall continues to be worrisome for rails (recall that well over half of the rail business is trade dependent or related). The OECD estimated global trade growth of 2.1% for this year; in 2017 it was almost 6%. McKinsey notes that 16 of its 17 “major industries” worldwide have contracted their supply chain….protectionism is on the rise of course, but the economy is slowing, threats (often IT-related) are increasing, ocean shipping getting more complicated (IMO2020) and erratic (slow steaming)….

3. Weather – It is the wettest year ever in the US and the Midwest is still drying out (estimated economic losses - $12.5B, worst of all-time) and the flooding disruptions still impacted Q2/19. In addition, the water-logged fields are leading to poor crop outlooks (the USDA reduced the corn production numbers by 8% from May). CP noted in its call the unprecedentedly long duration of the flood problems….

4. PSR – the operating changes have two impacts on volumes, plus two stages:

a. The first impact is the hard-to-quantify volume share loss as (some) shippers try to avoid playing in the revolutionary stages of the PSR story; this may be less pronounced than recent history since essentially everybody is doing it (as Matt Rose warned), but CSX is ahead of NSC and BNSF isn’t playing (I can hear the chorus – “yet!!”). This share historically returns, in spades, as the metrics improve….

b. The second impact is planned volume loss (AKA de-marketing) – we haven’t heard much about this, partially given the heightened STB focus on the process (after CSX) – but we do know that CSX planned a second ~7% volume reduction this year in Intermodal (roughly its current run rate, BTW – are they therefore running flat without the planned lane eliminations, etc?)

c. The first stage of PSR is creative destruction – lane closures, using assessorial charges to “change customer behavior,” cuts in personnel, etc

d. The second stage of PSR – We the North! – is (to quote CP) the “pivot to growth”!

5. Trucking competitiveness – after a year (2018) of extreme capacity shortage, the world has turned upside down – with one immediate effect of shrinking the historic gap between truck and rail/intermodal pricing. This will not last forever….

Q: Why do you think CP volumes are increasing while general rail industry volumes are dropping?A: While the industry and its investors is in general worried about volumes, CP grew volumes (both RTMs and, my preference, units) by 6% and revenues by 13%, beat the Street(s) by 15 cents and Q2/18 (adjusted) by fully 36%. By holding operating expenses (FXA) to a slight (1%) increase, they dropped their OR by 580bps – to 58.2%. and – kudos! – they announced their LTM ROIC was 16.8%. That – the result and the announcement of it – was huge. Other highlights:

All 6 operating/safety metrics improved, the latter, after a tough, cold Q1, by 25-30%.

They raised the DPS by 28% and stated they could raise their FCF Conversion rate from ~55% to ~75% in the next few years.

CEO Creel (et al) faced off on 3 basic questions, asked a few different ways:

Comparisons get tough in H2 (just as the economy may be cooling) – can you handle it? A: Yes – both in terms of lowering variable costs (and always reducing fixed costs) and due to planned growth in areas like autos, where business development led to 5% unit growth (+12% revenues) in Q2/19 – significantly better than auto traffic industry-wide.

So, aren’t they being too conservative in their OR projections (-100bps/year to the “mid-fifties”)? A: Perhaps….

CBR – how big and when? A: CP wont gamble capital on a short term business but expects a solid H2 (enough, along with autos, forest products, export coal and potash, and intermodal to make up for any overall slowdown this fall) and beyond – for 3-5 more years….

CP gained $35mm in incremental revenue from short lines YTD – a good yield from their renewed focus.